On April 8 of this year, Paul Volcker addressed the Economic Club of New York about the current crisis. The Federal Reserve, he noted, has gone to “the very edge” of its legal authority. “Out of necessity,” said Volcker, “sweeping powers have been exercised in a manner that is neither natural nor comfortable for a central bank”.1 He was referring to the $29 billion guarantee of Bear Stearns assets that had been extended to JP Morgan and the subsequent offer to swap $100 billion of Treasuries for illiquid bank assets. The Bear Stearns “rescue” was aimed at averting a dangerous situation in the default risk derivative market, and the swap operation sought to restore some liquidity to “frozen” markets. These were indeed unconventional measures, but ones without which more conventional interest rate policy could not be expected to have much effect in the current situation.
It is probably fortunate that the Fed had at its helm the most distinguished student in his generation of the Great Depression and someone, therefore, able to perceive the “necessity” more or less correctly. As in the Japanese case, the lesson of the Depression is that a collapse of credit cannot be reversed and that the consequences linger for a very long time. It is also true, however, that until only a year or two ago Chairman Ben Bernanke was a consistent and outspoken advocate of a monetary policy of strict inflation targeting, which is to say, of a central banking doctrine that required an exclusive concentration on keeping consumer prices within a narrow range with no attention to asset prices, exchange rates, credit quality or (of course) unemployment.
Bear Stearns, Northern Rock, and Landesbank Sachsen are the best known institutional victims of the current crisis – so far. But the damage is of course far more extensive and a great many CEOs have had to go into ignominious retirement with only a few million2 dollars as plaster on their wounded reputations. It is the rule of efficient capitalism that you must pay for your mistakes alas!
There are two aspects of the wreckage from the current crisis that have not attracted much attention so far. One is the wreck of what was until a year ago the widely accepted central banking doctrine. The other is the damage to the macroeconomic theory that underpinned that doctrine.3 In this column, I discuss two central tenets of modern central banking doctrine – inflation targeting and central bank independence.
Critical to the central banking doctrine was the proposition that monetary policy is fundamentally only about controlling the price level.4 Using the bank’s power over nominal values to try to manipulate real variables such as output and employment would have only transitory and on balance undesirable effects. The goal of monetary policy, therefore, could only be to stabilise the price level (or its rate of change). This would be most efficaciously accomplished by inflation targeting, an adaptive strategy that requires the bank to respond to any deviation of the price level from target by moving the interest rate in the opposite direction.
This strategy failed in the United States. The Federal Reserve lowered the federal funds rate drastically in an effort to counter the effects of the dot.com crash. In this, the Fed was successful. But it then maintained the rate at an extremely low level because inflation, measured by various variants of the CPI, stayed low and constant. In an inflation targeting regime this is taken to be feedback confirming that the interest rate is “right”. In the present instance, however, US consumer goods prices were being stabilised by competition from imports and the exchange rate policies of the countries of origin of those imports. American monetary policy was far too easy and led to the build-up of a serious asset price bubble, mainly in real estate, and an associated general deterioration in the quality of credit. The problems we now face are in large part due to this policy failure.
A second tenet of the doctrine was central bank independence. Since using the bank’s powers to effect temporary changes in real variables was deemed dysfunctional, the central bank needed to be insulated from political pressures. This tenet was predicated on the twin ideas that a policy of stabilising nominal values would be politically neutral and that this could be achieved by inflation targeting. Monetary policy would then be a purely technical matter and the technicians would best be able to perform their task free from the interference of politicians.
Transparency of central banking was a minor lemma of the doctrine. If monetary policy is a purely technical matter, it does not hurt to have the public listen in on what the technicians are talking about doing. On the contrary, it will be a benefit all around since it allows the private sector to form more accurate expectations and to plan ahead more efficiently. But if the decisions to be taken are inherently political in the sense of having inescapable redistributive consequences, having the public listen in on all deliberations may make it all but impossible to make decisions in a timely manner.
When monetary policy comes to involve choices of inflating or deflating, of favouring debtors or creditors, of selectively bailing out some and not others, of allowing or preventing banks to collude, no democratic country can leave these decisions to unelected technicians. The independence doctrine becomes impossible to uphold.
Consider as examples two columns that have appeared in the Wall Street Journal in recent weeks. One, by John Makin (April 14), argued that leaving house prices to find their own level in the present situation would lead to a disastrous depression. Policy, therefore, should be to inflate so as to stabilise them somewhere near present levels. If the Fed were to succeed in this, it might not find it easy to regain control of the inflation once it had gotten underway, particularly since some of the support of the dollar by other countries would surely be withdrawn. But in any case, the distributive consequences of Makin’s proposal are obvious to all who (like myself) are on more or less fixed pensions. The other column, by Martin Feldstein (April 15), argues that the Fed had already gone too far in lowering interest rates and is courting inflation. He was in favour of the Fed’s attempts to unfreeze the blocked markets and restore liquidity by the unorthodox means that Volcker had mentioned.
The likely prospect for the United States in any case is a period of stagflation. The issue is going to be how much inflation and how much unemployment and stagnation are we going to have. To the extent that this can be determined or at least influenced by policy, the choices that will have to be made are obviously not of the sort to be left to unelected technicians.
2 In one case apparently not all that few (reportedly 190 million!).
4 This focus is one of the legacies of Monetarism. Historically, central banks developed in order to secure the stability of credit.